index funds: When you invest in index funds, ETFs; should you choose Sensex or Nifty?

NEW DELHI: Yes, the cost of investing the ‘low-cost’ index fund is rising. All top fund houses have raised total expense ratio (TER) – or the fee that fund houses deduct from unitholders of index funds that track Nifty and Sensex – by at least 77% in recent weeks.

Yet, index funds or exchange traded funds (ETFs) are expected to continue gaining traction among investors, as most active fund managers have consistently failed to beat their respective benchmarks.

In India, the most popular index funds either follow the 30-share Sensex or slightly broader 50-share Nifty. Both indices act as heartbeat index of the Indian stock market to measure the performance of the largest listed companies.

So if you want largecap exposure to the market, and index investing is your style, which of the two indices should you pick? There is no right answer to this, but there are certain points that one can consider, and they include things as important as returns and diversification.

Analysts said in the long term it doesn’t really matter which index fund you are betting on, as there is hardly any difference in returns. Though in the short term, it is possible that one index might do slightly better than the other. Over a 10-year period, say, those would all even out.

For example, year to date, Nifty has returned 8.85 per cent while Sensex has delivered 6.28 per cent. But in the last 10 years, both have delivered about 182 per cent return.

So, what exactly leads to this difference in returns in the short term? Nifty is more ‘diverse’, as it includes more constituents. In the recent months, Nifty has outperformed Sensex because of a rally in the metal stocks. Nifty has three from the sector while Sensex has none.

Analysts believe investors should mind the concentration risk in index funds, which can be very high in a single stock even in comparison to an actively managed fund, which is mandated to keep allocation to one stock capped at 10 per cent.

“A look at the data a few days ago revealed that the top three Sensex stocks (RIL, HDFC Bank, Infosys) had total weightage of 31.57 per cent in the index, while the top five would (add HDFC and ICICI Bank) take it to 47.29 per cent. The bottom four stocks had an weightage of just 3.61 per cent (NTPC, IndusInd Bank, Bajaj Auto, ONGC),” said a Morningstar note.

Sensex has allocated nearly 12 per cent weightage each to HDFC Bank and

, while NSE gives the latter 10.2 per cent weightage in Nifty. HDFC Bank has less than 10 per cent weightage in it.

“The concentration risk is comparatively lower in actively managed funds. Sebi guidelines do not allow actively-managed equity schemes to own more than 10% in a single stock. After this limit is hit, the weightage of a stock in a scheme can go up only to the extent of the rise in its share price,” said Dev Ashish, a financial adviser at Stable Investor.

“So unlike the index itself (and the passive funds/ETFs replicating it), an actively-managed fund won’t have bets that are too concentrated or make the portfolio uncomfortably risky,” he pointed out.

Logically, the narrower the index, the higher the risk of concentration. Given that when investing in index funds, the investors want to eliminate certain risks, such as picking the wrong stocks, it is safer to bet on an index that has more constituents.

But, the diversification argument of Nifty50 against Sensex fails to hold when you consider the fact that 26 of its constituents have less than 1 per cent weightage in the index. Incidentally, this is also partly responsible for similar returns delivered by them in the long run, as most of these constituents do not have much sway.

Market commentators believe people who invest in index funds do so to largely avoid fund manager’s involvement. Concentration risk could be marginally higher in index investing, but if you are willing to take that risk, you are largely assured of getting same returns no matter whether the fund is pegged to Nifty or Sensex.